Latest / The Federal Reserve Podcast with Fexingo: Interest Rates, FOMC Meetings, and Monetary Policy / Why the Fed Is Watching the Iran War Energy Spike
Transcript
- Lucas: So the latest data from CNBC shows the average US household is now paying about $450 more per year on gas and energy directly tied to the Iran conflict. And that's not just a consumer pain point — it's becoming a real complication for the Fed. Luna: $450 — that's real money. And it's not going away as long as the war continues. Lucas: Right. And what's interesting is how Fed officials are talking about it. Chicago Fed President Goolsbee was on CNBC Thursday saying energy inflation has been 'more persistent than expected.' That's a notable shift in tone. Earlier this year, the consensus was that energy was transitory — spike, then fade. But we're in late May now, and the spike hasn't faded. Luna: Especially because the conflict is directly in a major oil-producing region. It's not like a refinery outage in Texas that gets fixed in a month. Lucas: Exactly. And the numbers back up the persistence. The PCE price index for April came in at 130.9, up from 130.38 in March. That's a 0.4% month-over-month rise, which annualizes to nearly 5% — well above the Fed's target. Core PCE, which strips out food and energy, hit 3.3% year-over-year, exactly as expected. But the headline number is being juiced by energy. Luna: And that puts the Fed in a bind. Because they can't fix energy supply shocks with interest rates. Lucas: Right. Minneapolis Fed President Kashkari was also out Thursday saying the inflation fight takes priority because the labor market is 'in decent shape.' So they're basically signaling: we're not cutting rates until inflation is clearly headed to 2%, and energy isn't cooperating. Luna: So what does that mean for the fed funds rate? The effective rate is still at 3.64, and the daily rate is 3.62. No movement. Lucas: No movement. And the bond market seems to agree. The 10-year breakeven inflation rate — that's the market's expectation for average inflation over the next decade — actually dipped slightly to 2.38%, down from 2.39%. That's still above the Fed's target, but the fact that it didn't spike on the energy news suggests traders think the Fed will hold the line. Luna: Interesting. So the bond market is saying: the Fed won't cut, but they also won't hike into a war. Lucas: Exactly. Look at the yield curve. The 10-year is at 4.45%, down about 0.9% over the last five days. The 2-year is at 3.59%, actually up slightly. So the inversion is still there — short-term rates are still higher than long-term rates. That's usually a recession signal, but the economy is still growing, albeit slowly. Luna: Right. And the stock market seems unfazed. The S&P 500 hit 7,580, up 1.4% in five days. The NASDAQ is up 2.4%. Small caps are up too. Lucas: That's the disconnect. Equities are rallying on hopes that the Fed will eventually cut, maybe later this year. But the bond market and the Fed's own rhetoric suggest no cuts until inflation is tamed. And energy is the wildcard. Luna: So how does the Fed even measure energy inflation's impact? Is it just the direct effect on CPI, or is there a second-order effect? Lucas: Great question. There are two channels. First, the direct effect: higher gas and heating costs show up in the headline CPI and PCE. That's straightforward. But the second-order effect is more worrying. If higher energy costs feed into the cost of producing and transporting goods, that can push up core inflation too. We saw that in 2022 — energy spikes bled into everything from airline tickets to groceries. Luna: And that's what Goolsbee meant by 'persistent.' It's not just the pump price; it's the ripple effects. Lucas: Exactly. And the longer the Iran war goes on, the more those ripple effects spread. The headline from CNBC about the 'double scar' — past inflation trauma plus current geopolitical shock — is exactly that. Consumers are still scarred from the 2021-2022 inflation surge, and now they're seeing energy costs jump again. Luna: And consumer sentiment hit a record low, which we covered a few episodes ago. So households are feeling squeezed. Lucas: Right. But the Fed has been clear: they can't let sentiment dictate policy. Kashkari said the inflation fight takes priority. So they're willing to tolerate low consumer confidence if it means breaking inflation's back. Luna: But here's the thing — if energy keeps rising, doesn't that eventually hit the labor market? If businesses face higher costs, they may stop hiring. Lucas: That's the risk. And it's why this is such a delicate moment. The labor market is still in decent shape, as Kashkari noted. But if the war drags on through the summer, energy costs could become a drag on hiring. That would give the Fed a reason to pause or even cut — but they can't cut while inflation is still above target. Luna: So they're trapped between a war and a hard place. Lucas: Pretty much. And the bond market is reflecting that uncertainty. The 30-year yield is at 4.99%, just under 5%, and it's actually been declining — down 0.7% in five days. That suggests long-term growth expectations are moderating, possibly because of the war's drag. Luna: So the long end is saying: maybe the economy slows, inflation falls, and rates come down. But the short end is saying: no cuts yet. Lucas: Right. And the Fed is firmly in the short-end camp. Chair Warsh has been clear: they need to see sustained evidence that inflation is moving toward 2%. A temporary energy spike isn't enough to change that stance. Luna: But how long is 'temporary'? The war started months ago, and there's no end in sight. Lucas: That's the million-dollar question. If energy inflation persists through the third quarter, the Fed may have to revise its forecasts. But for now, they're holding at 3.64% and watching. Luna: And that watching — it's kind of what we do here on this show. We look at the data, we connect the dots. If that's been useful to you, I know we keep it ad-free, and listener support is what makes that possible. Lucas: Yeah, it's a small thing that makes a real difference. A couple of dollars a month genuinely keeps these episodes going. If you've gotten something out of our Fed coverage, you can find us at buy me a coffee dot com slash fexingo. Luna: And we really appreciate it. Now back to the energy picture — one more thing I wanted to ask. How does the European yield curve factor in? We've talked about it before, but with the war in Iran, Europe is more exposed to energy shocks. Lucas: Great point. European bond yields have been rising because the ECB is also fighting inflation, and they're more vulnerable to energy supply disruptions. That's putting upward pressure on global yields, which makes the Fed's job slightly harder. But the U.S. is relatively insulated because we're a net energy exporter. Still, the global spillover is real. Luna: So even if the U.S. doesn't directly import much Iranian oil, the global price is set by the market, and that affects everything. Lucas: Exactly. And that's why the Fed can't just ignore it. They have to watch energy because it feeds into inflation expectations. If consumers and businesses start expecting higher inflation, that becomes self-fulfilling. That's the 'double scar' effect — past inflation makes people more sensitive to price increases now. Luna: So the Fed is really walking a tightrope. They don't want to overreact to a supply shock, but they can't afford to let inflation expectations become unanchored. Lucas: That's exactly it. And for now, their strategy is to wait and see. Hold rates, watch the data, and hope the energy spike fades. But if it doesn't, we could see them actually have to consider a hike — or at least a more hawkish stance — which would be a shock to markets. Luna: And that's the key takeaway from today. The Iran war is injecting uncertainty into an already uncertain inflation picture. The Fed is holding at 364, but the energy data is the one to watch. Lucas: Right. And as always, we'll be watching along with you. That's it for this episode of The Federal Reserve Podcast. We'll see you next time.